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Don't panic as stocks fall

The sky is falling, warn some observers of the global credit crunch that has erased a stunning 1,100 points from the TSX/S&P composite index in the past six trading days.

"Blood is hitting the streets. Everyone seems to be panicking, and there's reason to panic," Malaysian asset manager Patrick Chung told the London Evening Standard yesterday as stock markets in Asia, Europe and North America took another pounding. "We don't know when it's going to end. Liquidity is drying up."

But Sherry Cooper strongly disagrees. "The financial media are hyping the current global subprime liquidity situation and making it worse," the Bank of Montreal chief economist insisted in a recent research note.

"Much of what's happening is an unwinding of excessive risk-taking," says Cooper, who characterized the market turbulence as "a return to normalcy rather than a sign of impending doom."

Putting aside one's qualms when politicians assure us the economy is fundamentally sound, as Prime Minister Stephen Harper did Wednesday, the losers in this sudden liquidity drought are largely limited to sophisticated institutional investors and corporate deal makers who took on too much risk in pursuit of rapid, outsized gains.

And while their folly is not without the entertainment value that the financial media have indeed showcased in these dog days of summer, it doesn't pose a huge threat to the wider economy.

Bay Street and Wall Street will continue to lay eggs, and some of the $400 billion (U.S.) worth of planned corporate takeovers will be scrapped for lack of financing, but that's no reason to rush home from the cottage.

The current crisis has its origins in the era of easy money that followed the terrorist attacks of Sept. 11, 2001, when the U.S. Federal Reserve Board reacted by sharply reducing the federal funds rate, ultimately to a mere 1 per cent.

The resulting flood of cheap money begat a U.S. housing boom and a frenzied rush by subprime lenders to offer mortgages with no down payment and modest initial "teaser" rates to millions of low-income Americans with poor credit histories. Earlier this year, as the teaser rates expired and usurious ones kicked in, tens of thousands of Americans began walking away from their new homes.

Meanwhile, those mortgages had been "repackaged" and sold in bulk to global banks, including Canadian lenders, which by this summer raised questions about the health of their assets as the U.S. subprime default rate climbed to 20 per cent. That in turn curbed the bankers' enthusiasm for financing the parallel boom in multi-billion-dollar corporate takeovers, culminating in the proposed $51.7 billion (Canadian) leveraged buyout of Canada's BCE Inc.

Confidence underpins credit, and global bankers, facing losses on their subprime loans, began losing confidence that the corporate LBOs – acquired companies loaded with takeover debt – wouldn't follow the same pattern as the foreclosed Mississippi house trailers and inner-city Detroit bungalows on their books.

But for now, at least, it would appear that recession fears are unwarranted, especially in Canada. Most recessions are triggered by central bank rate hikes, and central bankers worldwide are far more likely to cut rates, to ease the credit crunch, than to raise them.

In contrast to the United States, government finances in Canada are strong. The recent implosion of the U.S. housing market followed a boom that didn't occur here. And even a weakened U.S. economy is reliant on Canadian energy exports.

The U.S. economic outlook is murkier, since the full extent of the subprime losses remains a guess. "The primary concern is that we do not know where the bodies are buried," Cooper says. The hedge-fund buyers of subprime and other dubious loans "do not disclose their holdings and markets are no longer trading much of the toxic waste related to spoilt subprime paper and credit-default swaps."

The corporate deal makers and their bank enablers would appreciate a lifeline from the U.S. Fed and other central bankers in the form of interest rate cuts. But it was cheap money in the first place that ignited the frenzy of lending that has marked the first half of the decade.

It will take fortitude on the part of Ben Bernanke, chair of the U.S. Fed, to keep the federal funds rate at 5.25 per cent at the risk of contributing to an economic slowdown. But the world financial community needs to restore prudence to its vocabulary after a string of previous Fed bailouts dating from the stock market crash of 1987.

"You don't want to see the Fed bail out these guys who have made a lot of money," a New York brokerage house trader told The Wall Street Journal on Wednesday, referring to the takeover maestros who take 2 per cent off the top of every deal they consummate. "They have made their bed and you want to see them lie in it."

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